Tim Duy’s Fed Watch, 8/2/22

Published on August 2, 2022
SGH Insight
Bottom Line: Expect more of this rhetoric from Fed speakers. The Fed remains committed to ongoing rate hikes until the inflation data rolls over for a sustained period. That basic messaging hasn’t changed even though the Fed looks forward to stepping down from 75bp rate hikes. It has simply been a challenge for the Fed to communicate its hawkish intentions when market participants have been looking for a dovish pivot. We expected this communications challenge, as well as a divergence between market pricing and the Fed’s intentions as economic growth eased. At some point, the Fed and markets will be realigned, and the data will decide whether the Fed needs to move to the markets or vice-versa. Today’s round of speakers indicates the Fed thinks the market will be the one that needs to move.
Market Validation
Bloomberg 8/3/22

*DALY: MARKETS ARE AHEAD OF THEMSELVES ON FED CUTTING RATES
*DALY: 3.4% IS A REALLY REASONABLE PLACE TO GET TO BY YEAR END
*DALY: JUNE SEP REMAINS A `REASONABLE GUIDE'
*DALY: ESTIMATE OF NEUTRAL RATE IS LITTLE OVER 3%, MAYBE 3.1%
*DALY: WE'RE NOT EVEN UP TO NEUTRAL RIGHT NOW
*DALY: OPTIMISTIC TO GET INFLATION DOWN WITHOUT A DEEP RECESSION
*DALY: WON'T BRING RATES DOWN IN JUST A FEW MONTHS
*DALY: BRING RATES UP TO LONGER THAN 6 MONTHS, MAYBE A YEAR
*DALY: 3% INFLATION STILL TOO HIGH, WHY WE HAVE A 2% AVG GOAL
*DALY: WE'RE DELIVERING ON 2% HOPEFULLY BY LATE '23, EARLY '24


“We’re going to have to see convincing evidence across the board of headline and other measures of core inflation all coming down convincingly before we’ll be able to feel like we’re doing enough,” St. Louis Fed President James Bullard says.
“We’ve still got some ways to go here to get to restrictive monetary policy,” he says in interview on CNBC. “We should get to 3.75 to 4% this year.”
“We’re going follow the data very carefully here and I think we will get it right,” he says
“I’ve liked front-loading. I think it enhances our inflation fighting credentials, keeps inflation expectations under control,” Bullard says
US economy “is not in a recession,” he says. “It’s hard to say that there was a recession with a flat unemployment rate at 3.6%. It’s hard to say there’s a recession”
Second-quarter slowdown was “more concerning,” first-quarter contraction “probably a fluke”
“We’ll get positive GDP growth in the second half”
“We’ll have a reasonably good third quarter here and so I think jobs will also hold up over the second half of the year job growth is slowing, but it’s slowing to a trend pace”

Swap markets indicate that the likely outcome of the September Federal Reserve policy meeting is now a coin toss between a 50-basis-point hike and a bigger increase of 75 basis points.
The rate on swap contracts tied to the date of the September Fed meeting on Wednesday rose as high as 2.958%, some 62.8 basis points above the current effective fed funds rate of 2.33%. That implies a hike of at least 50 basis points is seen as definite and a more than one-in-two chance that it could be three-quarters of a percentage point.
Traders have ramped up their expectations in recent days for the amount of Fed tightening at the next meeting in the wake of comments from various central bank policy makers indicating that they are firmly focused on combating inflation even as risks to growth loom over the horizon.



Mester, Daly, Evans Pushback, Waller Victory

As we expected, Fed officials are pushing back on the market’s dovish interpretation of last week’s FOMC meeting. Cleveland Federal President Loretta Mester was reliably hawkish today, saying that the Fed has yet to see inflation cool and she needs “very compelling evidence” that monthly inflation has fallen before she can be certain that the Fed has completed the job. She highlights the dominant role inflation plays in the Fed’s current reaction function:

The Federal Reserve is committed to bringing inflation under control, because it’s “a foundational piece of a healthy economy,” Cleveland Fed President Loretta Mester says.

“That’s what we’re about, what we’ve been about this year and will continue to be about until we get inflation under control,” Mester, who is a voter this year on the rate-setting Federal Open Market Committee, says in virtual interview with the Washington Post

This is reminiscent of Federal Reserve Chair Jerome Powell, who often points out that the economy just doesn’t work without price stability. Note that it doesn’t sound like Mester was swayed by the drop in the prices-paid component of yesterday’s ISM report, which wouldn’t be surprising. The Fed wants to see consumer-level inflation fall, so forecasts of falling inflation on the basis of firms’ costs aren’t enough. We should be careful with that ISM number; it largely reflects falling commodity prices, which, if this has an effect on inflation, will take time to pass through. I think inflation will prove to be sticky, and that is essentially the Fed’s working hypothesis until data clearly says otherwise.

Via Bloomberg, San Francisco Federal Reserve President Mary Daly said the Fed is “nowhere near” the end of the rate hike cycle, and reiterated the Fed’s objective of returning inflation to target:

“We have made a good start, and I feel really pleased with where we’ve gotten to by this point,” but inflation is “far too high,” Daly said in an interview on LinkedIn Tuesday. “We are still resolute and completely united on achieving price stability, which doesn’t mean 9.1% inflation — it means something closer to 2% inflation, so a long way to go.”

She also highlights a point we keep making – the Fed knows that it has been overly confident about inflation in the past, and now very much needs to see a better inflation path confirmed by compelling evidence in the data:

“It really would be premature to unwind all of that and say the job is done,” she said. “I also think that we’ve been with this high inflation for a while, and really getting too confident that we’ve already solved the problem,” Daly said, adding that the Fed needs to “keep committed until we actually see it in the data.”

And Daly pushed back directly on the market pricing in rate cuts by next summer:

“That’s a puzzle to me,” she said. “I don’t know where they find that in the data. To me, that would not be my modal outlook.”

Separately, Chicago Federal Reserve President Charles Evans said he supports what we have described as the glide path to the terminal rate. Via the Wall Street Journal:

“I’d rather have a path that more smoothly gets up to where we want and doesn’t have to retrace quickly for a reason that we weren’t expecting,” he said.

Daly expressed similar thoughts regarding the possibility of soon reversing course and cutting rates, saying such an approach would be “terribly hard” on the economy. This is consistent with our “higher for longer” thesis. The Fed seeks to push rates into a moderately restrictive range and hold them there for an extended period. It hopes to avoid setting in motion a “start-stop” cycle of activity. Evans’ outlook for the September meeting mirrors ours:

“The kinds of things that would make larger rate increases more important, like in September, would be if you really thought things weren’t improving,” Mr. Evans told reporters at a briefing Tuesday. “I think that there’s enough time to play out that 50 [basis points] is a reasonable assessment, but 75 could also be OK.”

I think the Fed would like to be able to step back to 50bp in September, but the risk is the inflation data keeps it on track for another 75bp. Arguably, the Fed could also opt for the bigger hike if it feels a need to push back even more aggressively on the idea that the era of rate cuts is already in sight. Beyond September, Evans hopes the Fed can downshift again to 25bp rate hikes at the November meeting; we have been cautious that the inflation data will support reverting to a “measured” pace before the December meeting.

The JOLTS report revealed a sharp drop in job openings from 11.3m in May to 10.7m in July while the quits rate held steady at 2.8%:

This for the Fed is definitely a step in the right direction, and it must be welcome news for Federal Reserve Governor Chris Waller, who has been pushing the thesis that a lower rate of job openings can cool the labor market and ease inflationary pressures without needing a recession. Still, openings have a long way to fall before the labor market achieves more balance:

Continued movement in this direction, however, would help support the case for 50bp in September.

Bottom Line: Expect more of this rhetoric from Fed speakers. The Fed remains committed to ongoing rate hikes until the inflation data rolls over for a sustained period. That basic messaging hasn’t changed even though the Fed looks forward to stepping down from 75bp rate hikes. It has simply been a challenge for the Fed to communicate its hawkish intentions when market participants have been looking for a dovish pivot. We expected this communications challenge, as well as a divergence between market pricing and the Fed’s intentions as economic growth eased. At some point, the Fed and markets will be realigned, and the data will decide whether the Fed needs to move to the markets or vice-versa. Today’s round of speakers indicates the Fed thinks the market will be the one that needs to move.

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